Bigger isn’t always better, especially when it comes to private equity. Smaller and emerging funds tend to outperform their larger counterparts for various reasons.
For one, private equity firms face diseconomies of scale as they grow larger. Another reason is that private equity firms can exhaust their capacity to grow, all while fees represent a significant profit center for these firms.
But perhaps the most compelling reason is that smaller and emerging funds deploy capital faster. They can move more quickly on deals and recycle their capital into new investments at a rapid pace. For all these reasons, it’s no wonder that small-cap buyout funds have outperformed their mega counterparts in recent years.
If you’re looking for superior returns in private equity, don’t bet on the big boys. Instead, keep an eye out for smaller, emerging funds poised to outperform.
Private Equity’s Diseconomies of Scale
As private equity firms grow larger, they face several challenges that can lead to subpar returns.
One such challenge is the diseconomies of scale. As these firms take on more investments, they spread themselves thin and cannot provide the necessary oversight and support to each company.
As an Invesco study explains, “once a venture capital fund grows beyond $400-500 million in size, performance often begins to suffer. It is challenging for firms managing large pools of capital to achieve venture-type returns when most exit outcomes occur at relatively modest valuations.” According to the study, the average IRR for funds under $400 million was 19 to 20%, compared to funds of $400 million to $1 billion with an IRR of 7.2% and funds above $1 billion with an IRR of 2.4%.
Communication and hierarchy costs can also rise as a firm grows larger. With more employees and more layers of management, there is potential for miscommunication and a general lack of cohesion among team members.
A Journal of Finance and Quantitative Analysis paper aptly titled “Giants at the Gate: Investment Returns and Diseconomies of Scale in Private Equity” found “investments held by private equity firms in periods with a high number of simultaneous investments underperform.” The authors also noted that “private equity firms’ actions do not appear to be mechanical or easily scalable.”
In other words, bigger is not always better regarding private equity. Their size often hinders the largest firms, leading to subpar returns. The reason is simple: A smaller fund means smaller checks, naturally making generating higher returns easier.
Consider, for instance, a team that successfully invested $100 million in 10 companies worth $10 million each, turning them into $20 million companies. If that team were to invest $1 billion in the same way, they would need to find 100 companies worth $10 million each. But as deal sizes increase, so does competition, making it difficult to find such opportunities.
Competition increases, and the team operates in a different market altogether. To succeed, they would need to have a deep understanding of that market, which can be challenging to achieve when managing an extensive portfolio of investments.
Private Equity’s Capacity to Grow
Private equity firms can also exhaust their capacity to grow. A Financial Times article warns that “private capital firms, like the traditional conglomerates they have largely supplanted, could soon exhaust their capacity to grow while still earning high returns.”
As these firms get bigger, they face an increasingly difficult time putting their capital to work. They either have to find more and more companies to invest in or put more money into each company. But doing either of those things can be difficult, if not impossible.
Investing in more companies can be challenging because there are only so many good opportunities. And investing more money into each company can lead to over-investment, ultimately hurting returns.
In contrast, small and emerging private equity firms have no such problem. They can quickly deploy their capital into new investments and see superior returns. As an S&P Global article notes, “US small-cap buyout funds outperform mega vehicles.” The reasons for this outperformance are manifold, but one of the most important is that small-cap funds can deploy their capital more quickly.
They’re also able to develop and resell their acquisitions more quickly, recycling their capital back into new investments at a rapid pace. This is in contrast to larger firms, which often struggle to do either.
Fees at Ever-Larger Funds
Private equity firms have long been criticized for their high fees. But many people don’t realize that these fees have become a significant profit center for these firms.
As MJ Hudson, an asset management consultant, noted in a 2018 report, “while management fees for larger funds are falling, the size of funds have increased so substantially that these fees represent a ‘significant profit center.'”
This is one of the reasons why private equity firms have been able to grow so large. They’re generating enormous profits from their management fees, which they use to buy more assets. This creates a vicious cycle that can be difficult for smaller firms to compete.
But it’s also important to note that these high fees often come at the expense of returns. In other words, private equity firms are sacrificing returns to generate more profit. This is something that investors should keep in mind when considering whether or not to commit capital to a private equity firm.
Smaller Funds Take Off
Private equity is evolving, and smaller firms are leading the charge.
According to PitchBook, “micro-funds continue to proliferate the market.” This is happening for various reasons, but one of the most important is that these firms can generate superior returns.
Smaller private equity firms are unencumbered by the problems that plague their larger counterparts. They don’t have to worry about diseconomies of scale or exhaust their capacity to grow. And because they’re able to deploy their capital more quickly, they often see superior returns.
PitchBook research has found that “nearly 18% of first-time funds nab an internal rate of return (IRR) of 25% while later funds only exceed that number about 12% of the time.” So if you’re looking for high returns in private equity, it’s often best to bet on smaller, emerging firms.
How to Invest in Small and Emerging Funds
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